How Warren Buffett Defied Popular Thinking on Risk

Buffett shows how smart people can fail miserably in evaluating risk.

Warren Buffett was not the first great thinker to the utter the words in the quote shown above. A variation of the quote was first attributed the British philosopher Carveth Read and then to the famous 20th-century economist John Maynard Keynes.

Nevertheless, the Oracle of Omaha eagerly borrowed the concept to communicate an invaluable lesson on risk to shareholders of Berkshire Hathaway(NYSE:BRK-A)(NYSE:BRK-B). A decade prior, Buffett had drawn a line in the sand in his most famous speech ever, claiming that those who thought differently than he did about stock market risk were akin to those who wrongly believed the world was flat.

It was a bold proclamation from the humble man from Omaha. But it was another example of how he defied popular thinking time and again over the course of his career.

What we might call "dumb money" investorsTo begin with, the stock market as we know it today is a very recent phenomenon. The actual trading floor of the New York Stock Exchange didn't exist until 1903, and with this new mechanism came a new way of thinking about valuing assets – whether we needed it or not.

Assets that were traditionally long-term investments, including businesses, could suddenly be traded like commodities. Forget a twenty- or thirty-year time horizon. Shares in a blue chip company like General Electric could be bought around breakfast and flipped for a profit after lunch. And so they were, much to the chagrin of those who recognized the inherent contradiction.

The aforementioned economist Keynes pointed out the disconnect between the life of a long-term asset and the thought process of a short-term buyer in the following quote from 1930:

If farming were to be organized like the stock market, a farmer would sell his farm in the morning when it was raining, only to buy it back in the afternoon when the sun came out.

Put this way, flipping an asset like a farm based on hourly weather patterns sounds absurd. But the stock market allows so-called "investors" to engage in similar behavior on a daily basis, only in this case with businesses.

Nevertheless, this form of short-term speculation became more and more prevalent over time. Today, the average holding period of a stock is less than a week. In a sense, "trading" has triumphed over "investing," and this trend has given birth to an entirely new method of assessing the risk presented by a company's stock.

When ownership in a stock is measured in days or weeks rather than years, risk becomes a reflection of a stock's volatility – also known as its "beta." As the idea of beta grew increasingly popular in investing literature and academic circles, the long-term investor in Buffett became more incensed with the concept altogether.

In 1993, Buffett pounded the table on this issue in his letter to shareholders, excoriating the academics who preferred algorithms and regression analyses over the evaluation of business fundamentals.

How not to assess stock market riskSummoning the message introduced in his 1984 speech, "The Superinvestors of Graham-and-Doddsville," Buffett contrasted his approach to assessing risk with the one so prevalent among those perched in their ivory towers:

[W]e define risk, using dictionary terms, as "the possibility of loss or injury."

Academics, however, like to define investment "risk" differently, averring that it is the relative volatility of a stock or portfolio of stocks— that is, their volatility as compared to that of a large universe of stocks. Employing data bases and statistical skills, these academics compute with precision the "beta" of a stock— its relative volatility in the past— and then build arcane investment and capital-allocation theories around this calculation. In their hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than precisely wrong.

Buffett, at the time, had increased Berkshire's book value at a rate of 23.3% over the last 29 years. Along with the help of Charlie Munger, he had proven that buy-and-hold investing could produce tremendous wealth when put into practice.

Still, the very idea of long-term investing was being undermined by professors teaching at top-notch institutions across America. These were professors without a proven investing track record comparable to Buffett's who spent their time buried in data sets analyzing stock price movements instead of evaluating a business's fundamentals.

Their assignment of a value to beta could tell you whether the stock fluctuated wildly or remained relatively in-line with the broader market. That was it, however.

It told you nothing about whether you were paying less than a dollar for a business that was truly worth a dollar. And that's all that mattered to Buffett. Their insight, in other words, was lost on him, and he made this known to his shareholders.

How to apply Buffett's approachBack then, Buffett illustrated his point using a simple example with the stock of the Washington Post. To update his example, let's look back at the roller-coaster ride of the at-home coffee machine company Keurig Green Mountain (NASDAQ:GMCR). As you can see in the chart below, this stock has experienced its share of highs and lows since the beginning of 2011:

An investor interested in Keurig's stock in early 2012 would likely want to know the risk he or she would be taking on in buying shares. In terms of beta, the investor would conclude that this stock's risk fluctuated dramatically in the year prior to hitting its 52-week bottom: Shares in Keurig garnered a beta of anywhere from roughly .8 to roughly 1.15 during that timeframe. Was this acceptable for the investor? Did it tell you something about the company that would help you sleep at night as a shareholder?

Buffett would point out that this investor was missing the forest for the trees. In 2012, Keurig faced severe business risks unrelated to the movement of its stock price. First among those risks was whether the company could continue to prosper after the expiration of the company's patent on K-Cup technology. The patent, in the eyes of many analysts, seemed like a critical ingredient in its successful "razor-and-blade" business model. To think that the stock price movement introduced a larger threat than a key aspect of Keurig's success to-date is simply ludicrous.

Those analysts who did their research and concluded that Keurig could succeed even after the patent expiration were the ones who likely profited from Keurig's rebound. And those investors fretting over the wild gyrations of the stock price around this time were probably hung out to dry.

Think like Buffett, and you too can profitOver the years, Buffett's expressed his distaste for using beta to assess risk on numerous occasions. In his eyes, it's completely detached from the actual machinery that powers a successful business. Simply put, it's a distraction for investors that need to be focused on the value of a business relative to its trading price, and not the fluctuations of the latter.

Let the mathematicians and academics find false precision in their calculations, he might say, but long-term investors should keep their finger on the pulse of the actual business – not the whims of the market.

Isaac Pino, CPA owns shares of General Electric Company. The Motley Fool recommends Berkshire Hathaway and Keurig Green Mountain. The Motley Fool owns shares of Berkshire Hathaway and General Electric Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Isaac covers the companies that constantly push the world forward, from the engines of innovation like GE and Google to the rule breakers like Chipotle and Whole Foods. He admires the leaders that embody the philosophy of Conscious Capitalism.
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